How Safe are ETNs?
By Ron DeLegge, Editor
November 5, 2009

SAN DIEGO (ETFguide.com) – Global stock markets have risen from the ashes. Credit markets are in the midst of a recovery. And the appetite for risk taking has returned. 

The implosion of exotic financial products like credit default swaps (CDS), collateralized debt obligations (CDOs), and auction rate securities (ARS) seems like light years ago. Given a few more quarters of steady growth, I’m sure a certain segment of the population will start doubting these diseased products ever existed.

But what about exchange-traded notes or ETNs? Now that the market has risen, are they any safer?

ETN Basics
ETNs are unsecured debt instruments that pay a return linked to the performance of an index, a currency or a commodity. In a similar arrangement to investing in bonds, ETN payments rely on the full credit and faith of the institution backing the product. Many ETNs have a long-term maturity date that can be anywhere from 20 to 30 years.

The iPath Dow Jones-AIG Commodity Index Total Return ETN (NYSEArca: DJP), the iPath S&P GSCI Total Return Index ETN (NYSEArca: GSP), and the iPath S&P GSCI Crude Oil Total Return Index ETN (NYSEArca: OIL) are among the most popular notes.

Other ETNs track narrow indexes with leverage and shorting strategies.

Examples of this include, the PowerShares DB Gold Double Short ETN (NYSEArca: DZZ), the PowerShares DB Crude Oil Double Short ETN (NYSEArca: DTO), and the PowerShares DB Agriculture Double Short ETN (NYSEArca: AGA).

At the end of October, there were 84 U.S. listed ETNs with around $7.6 billion in assets according to the National Stock Exchange. Among the top ETN providers are Baclays’ iPath notes ($5.2 billion), Deutsche Bank ETNs ($829 million) and Swedish Export Credit ($771 million).

The Sales Pitch
The typical ETN sales pitch will go something like this: “In order to be more diversified, Mr. & Mrs. Jones, your portfolio will require exposure to hard to reach asset classes like commodities, currencies, or other unique opportunities.”

In other instances, the sales pitch will focus on how certain ETNs are tax-efficient instruments. The pitch might even include mentioning how ETNs benefit from zero tracking error, which basically means you get identical performance to the underlying index or security, minus your fees. But before you bite, know the full spectrum of risks.

Taxation Risk
Under the current tax law, commodity and equity linked ETNs are taxed as prepaid contracts. This means investors incur tax consequences only upon the sale, redemption, or maturity of their note. However, this tax loophole is likely to disappear in the future.

In late 2007, the Internal Revenue Service issued an adverse tax ruling on currency linked ETNs. The rule stated that any financial instrument linked to a single currency regardless of whether the instrument is privately offered, publicly offered or traded on an exchange should be treated like debt for federal tax purposes. ETNs linked to commodity and stock baskets aren’t likely escape IRS rules for much longer. This looming tax risk is almost never mentioned in the ETN sales pitch.

Credit Risk
For investors relying on the safety of credit ratings to help them locate a safe ETN issuer, think again.

The 2008 credit crisis taught us about the danger of trusting hapless credit raters. Financial institutions like American International Group (NYSE: AIG), Lehman Brothers and others that were blessed as “sound” were anything but. Their financial situation deteriorated so fast and unexpectedly, not even the hallowed credit rating agencies could keep up.

While major ETN sponsors like Barclays PLC (NYSE: BCS) and Deutsche Bank AG (NYSE: DB) appear to be financially sound, gold-glittered credit ratings are far from a guarantee things will remain the same.  

After a few short months of being launched in 2008, Lehman’s Opta ETNs never delivered on their promise. Lehman collapsed and note holders got the same second class treatment as the rest of the defunct company’s creditors.

Market Risk
ETNs also carry market risk, which comes with any investment product. The underlying securities may not perform in a manner that produces a capital gain for the investor.

Let’s review what you’ve just learned: ETNs carry credit risk, taxation risk and market risk. Why that’s three strikes! Just make sure, you’re not the one striking out.  

Conclusion
Buyers of ETNs should not let a rise in global stocks trick them into a false sense of security.

Purposeful investing should be quick to reduce financial risks, not increase them. Along with market risk, ETN investors also bear credit and taxation risk. As the Lehman ETN blowup illustrates, if the company backing the products goes out of business, ETN investors are left in the lurch.  

All of the asset categories that investors need to build a fully diversified portfolio are already being well covered by index ETFs. You don’t need exposure to the Japanese Yen or some other specialized investment strategy to be diversified. And you certainly don’t need the additional risk of exotic financial products.